Tuesday, July 26, 2011

The Cameron government's austerity plan in the UK is near its one-year anniversary, and its effects continue to exactly match the prediction that any decent Macro 101 student could provide as the correct answer to a final exam question:

Growth in the UK economy slowed in the three months to 30 June, partly because of the extra bank holiday in April. Gross Domestic Product (GDP) grew by 0.2% in the second quarter, according to the Office for National Statistics, down from 0.5% in the previous quarter.

...Chancellor George Osborne said the growth was good news, but Ed Balls accused him of choking the recovery. "The positive news is that the British economy is continuing to grow and is creating jobs," said Mr Osborne.

...But shadow chancellor Ed Balls said that the slowdown was a serious problem for the government and it should take steps to boost growth.

"These figures show that last year's recovery has been recklessly choked off by George Osborne's VAT rise and spending review," he said. "The economy has effectively flat-lined for nine months and this is very bad news for jobs, living standards, business investment and for getting the deficit down."

...The think tank the Institute for Public Policy Research (IPPR) was also critical of the level of growth. "Last June, the OBR [Office for Budget Responsibility] predicted GDP would grow by 2.6% in 2011, but even if the economy gets back on track in quarters three and four this year, it will barely reach 1.2%," said IPPR director Nick Pearce.

It's not mysterious: when you raise taxes and cut government spending, growth slows. And when you do that during a very fragile and weak recovery, you can push your economy back into recession, or at best, choke off growth almonst completely. That's exactly why, as has been extensively written about both here and elsewhere, austerity during a time of economic weakness is not a good way to beat a budget deficit, and will be largely self-defeating.

And NO, in answer to the various comments and emails that follow every time I make this point: this doesn't mean that I think we should always and endlessly expand government spending. It just means we should expand government spending when economic growth is weak and unemployment is a problem. And that appropriate expansionary policies will reduce unemployment, improve income, and also effectively reduce the deficit in the long run.

This week the General Assembly adopted a non-binding resolution that aims to make happiness a "development indicator". Bhutan's ambassador Lhatu Wangchuk told the BBC the next step was to help UN members better understand the concept.

He admitted some were sceptical when Bhutan started lobbying for the resolution 10 months ago. But ultimately it won 66 co-sponsors, including the UK.

The idea is based on Bhutan's model of GNH, or Gross National Happiness, which measures quality of life by trying to strike a balance between the material and the spiritual.

The resolution invites member states to draw up their own measures of happiness and contribute them to the UN's development agenda.

"It's basically an approach," said Mr Wangchuk. "Our initial idea was to bring the concept of happiness to the consciousness of the UN membership… because we know that GDP indicators are inadequate to address human needs."

People who are interested in the macroeconomy (including me) spend lots of time focused on GDP, also known as national output. (And which in theory should also equal national income.) In fact, GDP is typically considered to be the single best descriptor of a country's economic conditions. And there's good reason for that: if what you want to measure is the total amount of stuff (i.e. goods and services) produced by the millions of individual actors in an economy over a given period of time, then GDP is your indicator.

But remember that GDP only tells you about how much stuff the economy produced -- not whether that stuff was useful, whether it actually made people better off, or how it was distributed. What if you don't care so much about the amount of stuff produced by an economy, and instead care about the well-being of the individuals in that economy?

If you're more interested in the well-being of individuals, then GDP is lacking when used by itself. It's a helpful indicator, because it gives you an idea of the amount of resources available to be consumed by the individuals in the economy over a given people of time, and it's reasonable to think that to some degree and in some situations, having more resources at your disposal allows you to possibly be better off. But if you believe that having more stuff available to consume is only one of many ingredients to happiness, then GDP shouldn't be taken as the final word in the welfare of a country's citizens.

For whatever historical reason (Eric Weiner, in his funny and well-written book The Geography of Bliss, argues that it has a lot to do with the deep influence of Bhuddism on the country's culture), Bhutan's government has long championed the use of more direct measurements of welfare. Its king has stated that his goal for his country is not to just increase his country's GDP, but rather to improve Bhutan's Gross Domestic Happiness, or GDH, which is an official indicator calculated by the government statistics office.

Note that while Bhutan is at the forefront of this movement, other countries are slowly taking interest, such as the UK. In fact, The Guardian is reporting today that the Office of National Statistics has just released its preliminary thinking about how it would develop a national happiness indicator. (Read the Guardian article if you're curious to learn more about how such an indicator would be calculated.)

But it is little Bhutan that has finally been able to push this idea of the GDH statistic into the UN for discussion. And I think it's an important discussion to have. Because if you start thinking about the economic indicators you're using, what you're really doing is thinking about what matters to you in life and what your goals are. If the best goal we can come up with is the maximization of the amount of stuff available for consumption, then I guess we should just stick with GDP as the best measure of how we're doing. But doesn't that feel like a pretty small goal for our society?

Tuesday, July 19, 2011

It has not taken long, but increasingly attention is turning to the endgame of the eurozone crisis.

Everyone seems to accept that "the centre cannot hold, things fall apart". So every idea is in play: a break-up of the eurozone, Greece leaving, fiscal and political union, European bonds, a European treasury etc. It is at last being recognised that papering over and pretending cannot continue.

...What has changed is a recognition that Greece needs some debt relief. Almost every economist believes that at some stage Greece will default. It can be now or later. The debt-to-GDP ratio is heading for 170%. There is no way a country can escape that trap, particularly with an economy in recession. So a way has to be found to write off part of the value of the debts.

So a dozen schemes have been on the table... [and if] a solution is found a second Greek bail-out will be launched at a eurozone summit on Thursday. Of course the question will be asked: if Greece gets debt relief why shouldn't other countries? Steps may well be taken to extend the period of the bail-out loans already given to Portugal and the Republic of Ireland - as well as Greece - and reduce the interest rates.

...All of this may buy some time, some relief, but it won't address the wider issue: how to convince markets and investors that Europe has a plan to address its debt mountains at a time of low growth.

Take Italy. How will it find the growth to reduce its debt-to-GDP, which currently stands at 120%? Italy stands perilously close to the edge. All it takes is a 2% rise in its borrowing costs for it to struggle to pay its way.

Which is why so many people leap forward to the endgame.

Some say there is a choice. Europe could take a giant leap towards integration and so all debt would become European debt. It could only do this with fiscal union - and that almost certainly would need the backing of political union.

...Or: Greece is shown the door, offering it a sabbatical from the eurozone, allowing it the flexibility to default and devalue. A couple of other countries may have to follow too, but the core of the eurozone would be protected, and ringfenced. All of these countries could rejoin the single currency later. Nobody pretends it would be easy, but it might be preferable to risking the single currency.

There are a couple of reasons why we might care about the price of gold: if it tended to make other things more expensive, as oil does; if it told us something about market psychology, e.g. inflation expectations; if it was a good leading indicator for something. While some or all of these may have been true at times in the past, I don't think that any of them hold today, so the short answer to my question is no, I don't see any reason to care about the price of gold.

Wait a minute, you're thinking: gold is a classic hedge against inflation, and so the price of gold has always been viewed as a good indicator about where market participants think inflation is going. It turns out that the relationship between gold and inflation expectations is rather out-of-date; as shown in the chart below, the price of gold has not shown any correlation with inflation for the past 15 years or so. (Note that the green line shows one explicit measure of inflation expectations, by measuring the interest rate difference between bonds that are indexed against inflation compared to those that aren't.)

So the dramatic rise in the price of gold over the past couple of years does not seem to tell us anything about average market inflation expectations. Then what has caused that amazing price rise?

In looking at the data I was struck by how small (relatively) the worldwide market for gold really is. That means that relatively small inflows of funds into the market for gold could potentially have very large effects on the price of gold. And that in turn means that the price of gold could be very sensitive to a number of factors that have nothing to do with economic conditions or inflation.

The table below shows how much gold exists in the world, and its distribution. (Data is from the World Gold Council.) Most gold that has been brought above ground on Earth has been turned into jewelery. And even over the past couple of years, roughly 2,000 tons per year of new gold jewelery is produced. (Though keep in mind that a certain amount of gold jewelery is also recycled each year, so the net increase of gold that is in jewelery form is smaller than that.)

Surprisingly, over the past couple of years investment holdings of gold have risen by only about 3,500 tons. Comparing the total value of all investment holdings of gold at the end of 2007 with the end of 2010, we find that such holdings have risen by about $600 billion in value over that time, about $150 billion of which was due to a rise in the actual quantity of gold held for investment purposes, and the remaining effect due to the rise in the price of gold.

How much of a net inflow of money into the market for investment gold would have been necessary to cause the rise in the price of gold that we've witnessed recently? We can't say for sure without having a lot more specific data about supply and demand with which to estimate how sensitive the price of gold is to various factors. But we can put an upper limit on it: at most, the net influx of funds into the market for investment gold that lead to a near-doubling of the price of gold since 2007 was $600 billion (since that was the total increase in the value of investment gold).

In reality, it was almost certainly far, far less than that. If it takes an inflow significantly less than $600 bn to double the price of gold, it's reasonable to guess that a net influx of $100 bn, or probably even $50 bn per year into the market for gold investments would be enough to push the price of gold significantly and steadily higher. This is a small number, compared to the tens of trillions of dollars worth of other sorts of financial assets owned by households. See the table below for a summary of the financial assets owned by US households in recent years. (Source: Federal Reserve Board Flow of Funds data: pdf.)

So moving just 0.1% of the financial wealth of US households into gold could be enough to have a substantial impact on the price of gold. Note that the same can not be said of other asset prices that we care about; it would be difficult to discern any price effects whatsoever of a move of $50 billion more or less per year flowing into the stock market (valued at over $50 trillion around the world), the bond market (also with a total value in the tens of trillions of dollars), or real estate.

Given all this, what can we say about the steady rise in the price of gold in recent years? This analysis suggests that seemingly small phenomena could have big effects on the price of gold. For example, the increased demand for gold jewelery among millions of newly well-to-do households in China and India could be enough to do it -- if 5 million families per year each acquire a couple of pieces of gold jewelery (say perhaps 3 oz of gold), that would represent an increase in the demand for gold of $25 bn per year.

It's also conceivable that a good advertising campaign by gold producers could be enough to move the price of gold. Imagine that an effective, sustained advertising campaign, targeted at wealthy, conservative individuals in the US, is able to persuade 25,000 of them per month to switch a portion of their financial assets into gold. (Note that the target audience would be those roughly 3 million US households that have over $1 million in financial assets.) Suppose for the sake of argument that each of them is persuaded to shift just 5%, or $50,000, of their portfolio into gold. Such an advertising campaign would have the effect of pushing $15 bn per year into the market for investment gold -- very possibly enough to have a significant impact on the price of gold, given how small the overall market for gold is.

Note that a very similar thing happened to the market for diamonds in the middle of the 20th century. The DeBeers diamond cartel used an incredibly successful advertising campaign in the 1950s to cement the idea of the diamond as the premier gemstone, and in so doing permanently changed the value of diamonds.

Whether or not you like that analogy, the central point here is a very simple one. Since the market for gold is so small, its price may be strongly affected by things that have nothing to do with the economy. And since the price of gold tells us nothing about the state of the economy, it should no longer be considered to be a meaningful economic indicator. So I think that it's time to drop the price of gold from our daily headlines.

Saturday, July 16, 2011

The biggest news from the past couple of weeks regarding the euro-zone debt crisis has been the way that investors have added Italy to the list of countries that they are worried about. From this week's Economist:

EVER since Europe’s sovereign-debt saga began, euro-area policymakers have feared that the turmoil afflicting first Greece, and then Ireland and Portugal, would engulf larger economies. Most attention had focused on Spain, a country that remains in peril. This week, however, contagion spread to another and even more alarming place: Italy.

Starting on July 8th bond markets staged an unexpected buyers’ strike, driving yields on Italian debt to their highest levels in a decade. These violent moves were mirrored by sharp falls in the shares of Italian banks. Markets calmed in mid-week amid talk that the European Central Bank had started buying peripheral debt. But the psychological damage has been done. The possibility that Italy, the euro area’s third-largest economy and the world’s third-biggest issuer of government bonds, might be sucked into the debt crisis cannot now be denied.

But actually, in some ways the sudden involvement (albeit in a very limited way so far) of Italy in the crisis could be seen more as a reversion to a more normal state of affairs. Until 2010 Italian bonds were judged by the markets to be a more risky investment than Spanish bonds, as illustrated by the spreads over equivalent German bonds displayed in the first column in the table below. The substantially lower level of Spanish government debt (again, see below) was certainly the reason for this. And in fact, it wasn't until May of 2010 that yields on Spanish bonds surpassed those of Italian debt.

The perceived riskiness of the sovereign debt of any particular euro country is the product of multiple factors, the most significant of which are probably the size of the outstanding stock of government debt (which, at around 150% of GDP, is what has convinced most observers that Greece is now insolvent) and the size of the current budget deficit. Spain has recently had a larger budget deficit than Italy (about 9.2% of GDP compared to 4.6% for Italy in 2010), and has added about nine percentage points more to its stock of debt than Italy over the past few years, but Italy's stock of debt is still far, far higher.

Clearly investors have begun reevaluating the relative importance of these two factors when assessing the riskiness of sovereign euro debt. And in so doing, they may be starting to revert to the sentiment that the overall size of the stock of debt is just as important as the size of present budget deficits. So rather than be surprised at the recent reconsideration of the riskiness of Italian government debt, perhaps we should be surprised that it took so long.

Wednesday, July 13, 2011

Despite all the rhetoric and posturing we see in the media and in Washington D.C., it is safe to say categorically that the U.S. Treasury will not default on its debt after August 2nd, even if the debt ceiling is not raised. Not only will the Treasury be able to pay interest on U.S. debt obligations, but there is money for other essential programs as well. However, there will be some serious cutting that has to happen because spending clearly exceeds revenues.

Yes, quite. In fact, some specific numbers are provided in this column: federal spending would instantly have to be reduced by about $100bn per month. By the end of 2011 federal spending would be about $500 bn lower for the year than it would have been otherwise.

I've made this point before, but for numbers that large, anyone who wants to pretend to have some understanding about the economy has to think about macroeconomic effects. In particular, spending cuts of that sze would reduce the US's 2011 GDP by multiple percentage points. The Q3 and Q4 GDP growth rates wold probably be on the order of between -5% and -10%. Recall that during the recession of 2008-09, GDP only fell by about 4% in total. The unemployment rate would be likely to rise by several percentage points from its current level of 9.2%, to perhaps 15% or more of the US population. Recall that at its worst, the unemployment rate during the Great Recession only reached 10%.

So when you read someone blithely writing that the federal government will not default in the absence of a debt ceiling deal, and instead will merely have to trim excess spending, remember that what they're really advocating is a new and deliberately caused Great Depression. And not just in economists like me.

The past week has been a busy one for people worried that the Greek debt crisis will soon spread to other countries. Ireland and Portugal have long been seen as susceptible to going the same way as Greece, but recently Italy has joined the group of countries seen to be potentially vulnerable.

So like many, I’ve been thinking a lot about contagion this week. But even though it seems to be common knowledge in the business press that if and when Greece defaults the crisis will immediately deepen for other countries, cogent explanations for why that might happen have been scarce. So I think it’s helpful to try to get more specific about why we think the crisis might or might not spread further to Spain or Italy. That will help us better understand whether those fears are real or overblown.

Most of the economic literature about contagion has focused on its applicability to currency crises, such as the EMU crisis of 1992-3 or the “Asian Flu” of 1998. However, the logic is similar when applied to sovereign debt crises. As a reminder, here’s a list of some of the explanations that have been put forward to explain previous episodes where financial crises spread from country X to nearby and similar country Y:

a common external shock: whatever factor originally tipped country X into crisis has the same effect on country Y, so it will also push Y into crisis.

the “wake up call”: when country X enters a crisis investors suddenly reevaluate their portfolios for risk, and sell off assets related to any country similar to X, thereby precipitating a crisis for country Y.

liquidity concerns among common creditors: crisis in country X causes creditors (e.g. banks) to suffer losses that force them to sell off assets in country Y, precipitating a crisis in Y.

cross-market hedging among common creditors: crisis in country X means that the portfolio of creditors (e.g. banks) has suddenly become more risky on average, so they respond by reducing their risk exposure elsewhere in their portfolio, in part by selling off the assets of any similar country also seen as risky, such as Y.

political contagion: the actions taken to deal with the crisis in country X (e.g. dropping a fixed exchange rate, or in this case, default) make it less costly for country Y to do the same thing, and investors realize this, sell off the assets of country Y, and thus precipitate a crisis for country Y as well.

The thing that these mechanisms have in common is that they all create a process of self-fulfilling expectations, where a loss of investor demand or confidence causes a sell-off of assets, which causes a crisis, which validates the original loss of confidence.

But in the case of Greece, I don’t think that most of these sources of contagion are of real concern, simply because the crisis has been drawn out over such a long period of time now that investors and creditors have all had plenty of time to expect and plan for a Greek default. So I think that the only one of these possible sources of contagion that might apply in this case is the last one, which for convenience I’ve labeled “political contagion”.

If Greece is seen to default (and it seems likely that however the EU chooses to package and label the terms of the new Greek bailout, it will involve some sort of "soft default"), then investors will have been provided a demonstration of how a limited default could work for other euro countries. This poses an enormous problem for European policymakers. Whatever new bailout and debt restructuring they agree to for Greece -- especially if it substantially reduces the Greek debt burden going forward -- could prompt Ireland and Portugal to ask for the same terms. On the other hand, if the terms of the Greek deal do not sufficiently reduce Greece’s debt burden then the deal will have done nothing to resolve the fundamental issue of insolvency, and policymakers will be right back where they started at some point down the road.

But developments in the financial markets over the past week have reminded everyone that policymakers may need to worry less about Ireland and Portugal, and instead be more far-sighted and consider first and foremost the impact on Spain and Italy. Because when it comes to those two countries, it is clear to everyone that if the debt crisis takes serious hold on them then a financial crisis will become a financial catastrophe.

Paradoxically, one way to help cut off the speculation in the financial markets that Spain and Italy could at some point be candidates for bailouts and/or debt restructuring would be for the EU and ECB to be relatively generous with Greece. If the transfers to Greece from the core euro countries are large – so large that they are difficult for France and Germany to agree to – then investors will have to draw the conclusion that such a deal could never, ever be applicable to Spain and Italy. Spain and Italy are just too big, and the aid packages that worked for Greece would never be feasible for them. While that wouldn’t necessarily stop speculation that Spain and/or Italy might someday be unable to service their debts, it would definitely stop speculation that they would ever be candidates for a Greek-style managed default. And that might be enough to help.

Contact

The Street Light is written by economist Kash Mansori, who works as an economic consultant (though views expressed here are entirely his own), writes whenever he can in his spare time, and teaches a bit here and there. You can contact him by writing to the gmail account streetlightblog. (More about Kash.)